The drama of financial regulatory reform is, to a considerable degree, playing right into the industry’s hands.
I have several pet theories as to why this has happened. One is the fact that the drafting of new rules and the related horse-trading started before there had been any meaningful investigations, and more important, there did not seem to be much in the way of forensics in the offing. We had the FCIC, with a limited budget for this sort of exercise, tight timetable, and questionable structure, and SIGTARP, with real prosecutorial powers, but limited resources and a narrow mandate.
Attitudes shifted markedly with the disclosure of the Lehman bankruptcy report by Anton Valukas, and underwent a sea change with the SEC’s suit against Goldman over Abacus 2007 AC-1. But rather than
use the sudden change in public perceptions (and perhaps more important, media coverage) to reopen the scope of regulation, Team Obama is hell bent to get Something Done well before mid-term election, presumably to appease “populist anger”.
We seem to be missing a key lesson of the Great Depression, and that is likely by design, given the power of the financial services lobby. The abuses brought to light by the Pecora Commission helped secure the passage of securities reforms. And perhaps as important, it made clear to the banking industry that far-reaching changes were to be implemented. The 1933 and 1934 securities acts reflect a sophisticated understanding of market operations, precisely because some insiders were involved in the drafting of legislation. They recognized they were either going to be on the bus, or under the bus, and chose accordingly.
By contrast, the industry has done a very good job in maintaining a united front against reform. One example: a colleague, who has written a few articles that have appeared on the Internet related to credit derivatives. He has been asked to do expert witness testimony, both for plaintiffs (meaning against the big dealer banks) and for a big bank. Even though his work has been pretty technical in nature and does not implicate the bank in question, the bank and its attorneys are very uncomfortable with the fact that he has exposed tradecraft, and have made it clear that they do not want him publishing at all if he is to work with them. It is one thing to ask an expert witness to review articles pre-publication to make sure they do not compromise a client; quite another to put a gag order on someone who has a long-standing publishing history. Similarly, I have run across others who clearly believe abuses occurred, yet are unwilling to break ranks (and I don’t mean outing themselves, simply talking to an investigator or reporter on an deep background basis).
So the result is that we’ve had proposals come in late in the game that are crowd-pleasing but either ineffective or ill thought out, and that works to the industry’s benefit (they can beat them back, and the existence of a flawed proposal that is taking up legislative and press bandwidth makes it harder for other, better conceived measures to move forward).
One example of the ineffective sort is the so-called Volcker rule, to require depositaries to exit the proprietary trading business. On paper, this is a good idea, but the initial Volcker definition was to distinguish trades executed with end customer versus those that were not, which is not a helpful distinction (bond king Salomon Brothers did a tremendous amount of speculation in its regular trading books, long before there were separate prop desks). Although the language is still in play, banking expert Josh Rosner has said, via e-mail, “the Volker rule has holes large enough to drive 4 Mack Trucks through, side by side.”
By contrast, Blanche Lincoln’s proposal, to force banks to get out of the derivatives business (and the climbdown, to have those businesses separately capitalized), is misguided. The problem here is she and the media have fallen for a master stroke by the industry, that of lumping in credit default swaps with “derivatives”. CDS are highly problematic; they have almost no legitimate uses and come with considerable costs (hugely bad incentives). Moreover, the plans underway will not tame them much. They cannot be margined adequately on a contract by contract basis (any sufficient provision for jump to default risk would render the contract uneconomic and kill the product, which is an unacceptable outcome, so it will continue to be inadequately margined). The best remedy would be to regulate it like insurance (which is what it is) but no one is willing to change directions now.
Plain vanilla swaps, like simple interest rate and foreign exchange swaps are not problematic and customer pricing is pretty transparent. And the banks themselves use these products in large volumes to hedge their own exposures. The flaw in the Lincoln plan is that any derivative business running on an independently financed balance sheet would be unlikely to be large enough to handle the hedging needs of the banks themselves.
Via e-mail, Josh Rosner supplied a much better idea for how to handle banks’ derivatives books:
Instead of getting to the point where we talk of moving bank derivative activities into a new shadow system where end users begin to build insufficiently regulated dealer businesses (which the banks/i-banks would buy an unconsolidated interest in) why not require that the banks and the dealers no be allowed to speculate with derivatives. There is a precedent for this. In one of the few smart concepts in the former GSE oversight regime, the GSE’s were required to only use derivatives for hedging…in other words be as close, as realistic, to flat at the end of the day. They were required to put risk back into the market rather than aggregate it on their balance sheet.
In the case of the DEALERS, I would allow them to make markets but I would give them a time frame to get flat on the specific related exposures… a t+5-day type approach. While one could never be perfectly hedged on a delta basis, this is the right approach to minimize risk. That way their aggregate exposures, as market maker, would always be a function of the number of days of recent transactions and, if there was a crisis those number of days of recent transactions would likely be manageable. Moreover, knowing they had to get themselves flat they would be careful of the counterparty pricing and exposures they accepted.
From a former OFHEO official I have known for years:
Trading” of derivatives is not within the GSEs charter or mission. Dealers “make a market” in derivatives and can use derivatives to speculate. End-users use derivatives to control risk only. From a safety and soundness prospective, FHFA requires that the GSEs participate as end-users of derivatives for hedging purposes only and not as intermediary or dealer. Additionally, management assertions in the statement of financial condition (and in internal memoranda that documents the control process in risk management) are legally binding and those assertions (at the GSEs) include that derivatives are used only for hedging purposes.
Yves here. This is simple, elegant, effective….which means the odds of it happening are zilch. But we need to keep ideas like this front and center to remind us that there are some straightforward solutions to some of the complexity and opacity the financial services industry has created, particularly when they do shoot down other simple but misguided approaches.
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Yves, is there a single page of the regulations that you approve of and are “simple, elegant and effective”? would be great to hear your opinion on the rest of them.